Re-evaluating sustainable sovereign debt: A theoretic and econometric evaluation of the suggested new EU fiscal rule

Abstract

The Commission of the EU proposed a new fiscal rule in 2022 focusing on the primary surplus of governments in the euro area rather than on public deficits. This paper analyses the suggested new rule by setting up a simple optimal control problem. Governments determine the optimal reaction of the primary surplus to public debt such that the squared deviation from a certain target surplus is minimized. We study the structure of the model and highlight its implications for the economy's stability. In addition, we perform panel data analysis for euro area countries where we empirically estimate the fiscal space for each country. We apply panel smooth transition regressions to account for distinct regimes depending on the differences between the interest rate on public debt and the GDP growth rate of the economies.

Keywords: Public debt, primary surplus, fiscal rule, sustainability

JEL Classification: H61, H63, E62